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Look Out, Here Come the Grey Swans

Look Out, Here Come the Grey Swans

13 February 2020

The new year has gotten off to a wild start and investors are already seeing some of the ups and downs play out in the market. Lori Heinel, deputy global chief investment officer at State Street, has released five new grey swans as part of her 2020 outlook.

Unlike black swans, which swoop in out of nowhere and wreak havoc on portfolios, grey swans are scenarios that are plausible but not predetermined. Some could spell trouble for asset owners, but others could provide an unexpected portfolio boost.

Heinel’s Grey Swans:

  • Technology Gets De-FAANGed;
  • The Federal Reserve (Fed) Lets Inflation Run Hot;
  • A Spirit of Fiscal Cooperation Builds in Europe;
  • Chinese Policy Choice Roils Global Markets;
  • Cryptocurrencies Come of Age.

Big Tech Under the Microscope

Facebook, Apple, Amazon, Netflix, and Google – also known as the FAANG stocks – have had an unprecedented run. Now, regulators are taking a look. Both the Federal Trade Commission (FTC) and the Department of Justice (DOJ) have announced antitrust probes into Big Tech and Heinel says that of her grey swans, the potential for some type of regulatory move against the FAANGs is more likely than some of the others.

There are three big issues the FAANGs face: antitrust action, the potential for new taxes, and questions over who ultimately owns assets like consumer data.

“We don’t think a breakup is coming,” Heinel tells CIO. “But we do think there could be new restrictions on some of the activities these companies are engaged in. That could compromise the thesis that these companies can grow in perpetuity.”

Other potentialities like incremental taxes on digital goods or transactions could hurt margins. The most damaging option is a regulatory decision that puts data ownership or other intangible assets firmly in the hands of individuals. Business lines that rely on things like aggregate consumer data could be adversely impacted and that could hit share prices.

Writing in her grey swans outlook, Heinel notes, “The US Department of Justice uses the Herfindahl-Hirschman Index to measure market concentration, using 25 as a baseline for action. Internet retailing carries a Herfindahl-Hirschman Index value of more than twice that number (53), reflecting the handful of companies selling products online and running much of the cloud computing environment. Interactive media and services (Herfindahl-Hirschman Index value of 46) may also be vulnerable to regulatory action.”

At the portfolio level, investors may end up revising valuations for the FAANGs (goodbye, trillion-dollar club). They may also want to take a fresh look at value stocks which could come back into favor if the FAANGs, which have been primary drivers of growth and momentum factors, lose their teeth.

Schrodinger’s Inflation

The Federal Reserve’s preferred inflation indicator ticked upward in December and Fed Chairman Jay Powell said he feels confident inflation could start a move in earnest toward the Fed’s 2% goal. However, inflation hasn’t risen meaningfully in more than a decade despite prior indications that it might.

In her outlook, Heinel says there’s more of a chance now and the Fed may opt to let the economy run hot – especially if it equates to growth. “You could see import price inflation and wage growth start to put pressure on the Fed,” Heinel says. “You’re starting to see wage rigidity indices reflect people changing jobs so they can get more money. Minimum wage increases in select geographies are also putting upward pressure on the lowest wages.”

If the Fed lets the economy run hot and issues another rate cut, it could boost its credibility. If this happens, growth could help equities retain their value. If growth slows before markets see inflation return, classic hedges like TIPs or metals/mining stocks could make a comeback.

Europe Pivots to Fiscal Policy

Alongside Powell’s moves at the Fed, Heinel is cautiously hopeful that with Christine Lagarde at the helm of the European Central Bank, Europe could get serious about fiscal policy. The ECB and the Organization for Economic Co-operation and Development (OECD) have specifically called for countries with budget surpluses to invest to stimulate growth and reduce surplus to 0.5% of national GDP.

Lagarde has made public comments calling on the need for member states to support job creation and infrastructure spending, but it may still be a tough sell. Heinel says that the Eurozone’s cap on deficit spending has created a scenario whereby member states are hesitant to spend if it means going into their budget surpluses.

“We don’t think it would take a lot of spending to support growth and help policymakers see that being a little more relaxed is probably OK,” Heinel says. “There are more people in the room now with this view and that’s a good thing.”

If the ECB could pull off a grand bargain that allows it to taper its spending in exchange for incremental fiscal spending, markets could see a renewed interest in European equities. Emerging markets equities could get a boost as well.

China Treads Lightly

China started the year trying to maintain a delicate policy balance that supported growth, while also threading the needle on trade issues with the US. Then coronavirus hit, adding new pressure to Chinese markets and global supply chains. In 2020, the Chinese government will have to tread very carefully to avoid a major upset. 

Heinel is watching the trade talks closely and says that the Chinese government will have to ensure that trade discussions remain separate from other policy tensions with the US. The risk of default shock in China persists, which could roil global markets and impact China’s plan to deleverage its financial system. The Chinese government is under pressure to maintain the supply of easy money necessary to keep things running more or less smoothly.

If the government plays it poorly, investors could pivot to US Treasuries and yen, and out of risk assets geared to China—EM equities and European exporters.

Digital Fiat Currencies Move Closer to Reality

China is also working to offer a reserve currency alternative to the dollar. Creating a digital fiat currency may be the way it chooses to do that. The People’s Bank of China has already indicated that it plans to launch a digital fiat currency in the future. Heinel says the introduction of a digital fiat currency would be highly disruptive to the global payments system. China, which is less hampered by AML and other financial regulations, could be in a position to go first. 

“If they created a system that offers seamless transactions with little translation risk currency to currency, that would be significant,” Heinel says. The ability of residents and nonresidents to hold accounts with the central bank could also upend existing business models for banks and other providers.

It’s unclear what the total impact of a digital fiat currency would be, but it’s important to watch, as China isn’t the only jurisdiction considering digital fiat. Sovereigns and institutions will have to think through the potential impact to their portfolios and cryptocurrency exposure.


13 February 2020
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